Tax reform impact on executives of alternative investment funds
INSIGHT ARTICLE |
On Dec. 22, 2017, President Trump signed H.R.1 into law. The legislation, often referred to as the Tax Cuts and Jobs Act (TCJA), is a significant piece of legislation and many of the provisions went into effect Jan. 1, 2018. It is important to understand the impact of the major provisions affecting individuals, in particular, executives, founders and general partners of alternative investment fund structures such as private equity or hedge funds.
Please note that we can expect significant regulations and explanations from the Department of Treasury and Internal Revenue Service in the coming months to clear up many areas of ambiguity. The following tax reform provisions may have a deep impact to these taxpayers.
Individual tax rate decreases: The TCJA reduces the top individual tax rate from 39.6 percent down to 37 percent.
RSM insights: Arguably, the most talked about tax provision for high-income individuals is the personal income tax rate reduction. The rates at most income levels have dropped by about two percent, not to mention the expansion of the income brackets allowing for a further reduction in ordinary income taxes. Despite the overall decrease in ordinary income tax rates, the tax rule change on the cap for deductibility of state and local income taxes and real estate property taxes, along with the elimination of miscellaneous itemized deductions subject to the two percent of adjusted gross income (AGI) floor will possibly wash out some of the savings from the lower individual tax rates for fund executives, especially those living in high-taxed states such as California, New Jersey and New York.
Carried interest: As mentioned in RSM’s recent article “Private Equity fund and portfolio companies: The impact of tax reform,” carried interest rules were altered by adding a holding period minimum requirement of at least three years of an applicable partnership interest in order to qualify for the favorable long-term capital gain tax treatment for tax years effective Jan. 1, 2018. The portion of the carried interest that relates to gain on property held less than three years would now be considered short-term capital gain.
RSM insights: Overall, some general partners of alternative investment funds may continue to enjoy carried interest tax benefits that existed under prior law as long as the underlying investments that gave rise to the gain are held for more than three years as required under the new law. This may have more of a negative impact on hedge funds, since most private equity funds have longer term holding periods of applicable partnership interests. For funds that do not meet the three-year holding period, it will be important to determine if a capital loss position can be recognized to mitigate the negative tax impact. A strategy that may work is to accelerate or realize short- or long-term capital losses within a fund or personally offset any carried interest short-term capital gain with personal capital losses.
Pass-through income tax deduction: Section 199A of the TCJA provides owners of qualified pass-through businesses the ability to claim a 20 percent deduction from taxable income of qualified business income potentially creating a net effective federal tax rate of 29.6 percent compared to the new top ordinary income tax rate of 37 percent. A qualifying trade or business under this code section is defined as any trade or business other than a specified trade or business. Unfortunately, a trade or business of performing services (such as a management company) is included in this carve out.
In addition, an additional deduction limit was included under the rule if a partner’s taxable income exceeds $157,500 for single tax filers ($315,000 for joint filers) and will fully apply once taxable income is greater than $207,500 for single tax filers ($415,000 for joint filers). If subject to the limit, the deduction will be limited to the lesser of:
- 20 percent of the qualified business income or
- The greater of: (a) 50 percent of W-2 wages from the qualified trade or business or (b) 25 percent of W-2 wages from the qualified trade or business plus 2.5 percent of the unadjusted basis immediately after the acquisition of all qualified property.
As briefly alluded to above, it is important to note a carve-out for specified service trade or business, which will not allow for the 20 percent deduction to be used. These businesses include but are not limited to professional services such as law, accounting, management, health, consulting, actuarial or investment brokerage. Also excluded are businesses whose principal asset is the reputation or skill of one or more of its employees and/or owners, which involves the performance of services consisting of investing, investment management, trading in securities or similar services.
Qualified business income for the pass-through deduction does not include investment-type income (e.g., capital gains, dividends and nonbusiness interest). The TCJA did try to appease specified service businesses right before final signing by President Trump, by allowing specified service business owners the 20 percent deduction as long as the taxpayers’ taxable income doesn’t exceed $207,500 for single filers ($415,000 for joint filers), subject to a phase-in of the wage limitation discussed above beginning at $157,500 for single filers ($315,000 for joint filers). In contrast with qualifying businesses mentioned previously, if the taxpayers’ taxable income exceeds $207,500 ($415,000 for joint filers) no deduction is allowed for the specified service business such as in the fund management space. This may be helpful for some taxpayers at lower levels of taxable income, but overall does not help many alternative investment fund management company members due to the lower-income limitation.
RSM insights: Many alternative investment funds generate income (dividends, long-term capital gains, etc.) that will likely not qualify as qualifying business income for this provision. However, if a U.S. partnership such as a private equity fund has portfolio investments such as flow though portfolio companies that are engaged in a U.S. trade or business which generate qualifying business income and have W-2 wages, it is possible that the individual limited partners and the general partners of the private equity fund could benefit. Similarly, in a co-investment scenario, where fund investors, fund sponsors’ operating partners and/or fund principals invest directly in a pass-through portfolio company, the deduction may be possible.
Itemized deduction changes: The TCJA has made several changes to itemized deductions:
- Placed a limit of $10,000 on an individual taxpayer’s combined itemized deduction for state and local income taxes and real estate taxes.
- Eliminated the miscellaneous itemized deductions subject to the two percent of the adjusted gross income (AGI) floor, including but not limited to investment fund management fees.
- Limit on home mortgage interest deduction to the first $750,000 of acquisition indebtedness on newly purchased principal and secondary residences after Dec. 15, 2017.
- Elimination of the home equity interest deduction if not qualified.
RSM insights: This will undoubtedly affect a significant number of individuals in the hedge fund and private equity world who happen to live in high taxed states like California, Connecticut, New Jersey and New York to name a few. The limited cap on the state and local income tax and real estate tax itemized deductions will offset the majority of the benefits previously mentioned. Choosing or moving state residency of fund executives may become a hot topic given these tax reform changes.
Alternative minimum tax (AMT): The TCJA has left the AMT in place for individual taxpayers but has increased the exemption amounts to $70,300 for single filers ($109,400 for married taxpayers filing jointly) compared to $54,300 and $84,500 respectively in 2017.
RSM insights: In addition to the increase in the exemption amounts mentioned above, the phase-out thresholds have also increased from $120,700 to $500,000 for single filers and from $160,900 to $1 million for married filing jointly. Due to the increase in the AMT exemptions, the increase in the phase-out thresholds and the reduced AMT income add-backs of state and local income taxes and property taxes and miscellaneous itemized deductions subject to the two percent of AGI floor, we anticipate a significant decrease in the number of individual taxpayers who are subject to the AMT beginning in 2018.
Estate and gift tax exemption increase: With the passing of TCJA, the estate and gift tax lifetime exemptions have increased to about $22.4 million for a married couple beginning on Jan. 1, 2018.
RSM insights: The near doubling of the estate and gift tax lifetime exemptions to about $22.4 million (inflation adjusted) will provide an excellent opportunity for wealthy Americans to maximize their estate and gift tax planning. Most, if not all, estate plans should be reviewed at this point in time to take advantage of this opportunity. One thing to consider is the fact that this provision is temporary and is set to sunset at the end of 2025. Therefore, fund executives who have accumulated substantial wealth either in their fund interests or through personal investments, should consider the ability to make transfers before 2025. This, combined with the exemption increase, along with the fact that proposed regulations under IRC section 2704, which relate to limiting valuation discounts of interests in family-controlled entities for gift, estate and generation-skipping transfer tax purposes have been repealed will make for a great tax environment for hedge fund and private equity owners to consider additional gifting transactions starting in 2018.
Limitation on excess business losses of noncorporate taxpayers: For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, the TCJA disallows a deduction for business losses (excess deductions, which are attributable to trades or businesses) in excess of business income plus $250,000 for individual filers ($500,000 for joint filers) for the current taxable year. These losses will be carried forward and treated as a net operating loss carryforward into future years. The limitation will apply after the application of the passive loss rules under section 469. In the case of partnership and S corporation losses, the limitation will apply at the partner or shareholder level.
RSM insights: Owners of a management company or pass-through portfolio company will be limited from using losses from the management company or pass-through portfolio company to offset other income of that individual partner or shareholder if the losses exceed the threshold amount provided under the new provision.